GDP or Gross Domestic Product is the biggest indicator of a country’s economic health. It is a total of the monetary value of all completed goods and services developed by the citizens or residing foreigners of a country within the geographical borders in a definite time period.
To calculate the GDP of an economy, one is required to add the following together:
- Personal consumption expenditure
Personal consumption expenditure is an aggregate of how much money a nation’s citizens spent on goods and services in a year. It gives an estimation of national consumer spending.
- Private domestic investment
Businesses spend money to promote the growth of their businesses like buying machinery, workspace, etc. The measure of this investment made by businesses in an economy is known as private domestic investment and it is an indicator of the productive capacity of an economy in future.
- Government consumption expenditure
Government consumption expenditure is an aggregate of the expenditures made on goods and services like equipment, infrastructure, payroll, etc. These are used for the direct satisfaction of individual or collective requirements of the citizens of the nation.
- Exports fewer imports
Net exports is the calculation of total exports made by an economy subtracted by the total imports that are brought in. All the expenditures made by a firm, be it Indian or foreign, are included in the calculation.
The GDP is usually represented in percentage and is calculated on a quarterly basis in most countries. In retrospect, quarterly GDP growth rates analyze the periodic performance of an economy but, it is the annual GDP figures which show the true picture of the overall economic size of a country.
The Central Statistics Office (CSO) is responsible for calculating the GDP growth rate of India. Operating under the Ministry of Statistics and Program Implementation, the CSO is in charge of macroeconomic data collection and all the statistical record keeping. Among its tasks, the CSO is responsible for conducting annual surveys of industries and compile several indexes. These include the Index of Industrial Production (IIP), Consumer Price Index (CPI), etc.
To achieve these tasks, the CSO works in coordination with different federal and state government departments to gather and compile the necessary data needed to calculate the GDP growth rate of an economy.
Nominal vs. Real GDP
GDP of a country is calculated in two different manners providing us with nominal and real GDP.
- Nominal GDP
When calculating the Nominal GDP of an economy, only the prevailing market prices of goods and services are taken into account. These numbers don’t factor the inflation or deflation in prices and only considers the natural movements of prices. This implies, with nominal GDP, only the gradual fluctuation of an economy’s value over a period of time is tracked.
- Real GDP
On the contrary, in the calculation of real GDP, factors like inflation and deflation are taken into account. To analyze the overall growth of various countries of the world economy, economists prefer using the real GDP. Price deflator is used to calculate the real GDP which is basically the difference in prices of goods and services in current and base year. This helps in the accurate analysis of any real growth in the economy between two years.
How is GDP really calculated?
The two most basic approaches to calculating the GDP of an economy are the income approach and expenditure approach.
- Income Approach
Also referred to as the GDP(I), this approach requires economists to add up total compensation paid to employees, gross profits for incorporated and nonincorporated firms and the taxes minus the subsidies.
- Expenditure Approach
A more commonly used approach, the expenditure approach calculates the total consumption, investment, government spending and net exports made by an economy.
Both these approaches should roughly lead to the same total. This will give us the nominal GDP of an economy. For the real GDP, we are required to make some adjustments for inflation.
Adjustment for Inflation
In an economy, prices of various commodities and services tend to increase over a span of time. This change is the price is reflected in the GDP making it difficult to analyze if the economy actually grew or if it was just an increase in the prices.
To cater to this issue, economists make an adjustment for inflation in the nominal GDP to come up with a country’s real GDP. The formula used to reflect the real GDP of an economy is given below:
Real GDP = GDP / (1 + Inflation since base year)
Here, the base year is the term used to identify the designated year which is used as the reference for growth analysis. It is used as a comparison point by economists to analyze economic data like the GDP.
To calculate the real GDP growth rate, the calculation is done as follows:
Real GDP growth rate = (most recent year’s real GDP – the last year’s real GDP) / the previous year’s real GDP.
Why do we use the Real GDP Growth Rate to analyze an economy’s performance?
It is obvious that the real GDP growth rate gives a more realistic picture of the economy as compared to the nominal GDP growth rate because it takes into account the effects of inflation on the economic data.
It avoids the distortion of the figures caused by periods of significant inflation or deflation making it a more reliable and consistent measure.
Conclusion
The true status of the world economy is analyzed by the GDP growth rates of various countries. Most countries employ the above-mentioned approaches to reach the most accurate figure of their economic growth. The GDP growth rate of India is also analyzed by employing these measures. Maintaining the accuracy of the data and figures used is of prime importance to bring forth the true health of an economy.
